Mezzanine Finance White Paper 2Nd Edition

Mezzanine Finance White Paper 2nd Edition

Corry Silbernagel Davis Vaitkunas

Amendments to Mezzanine Capital Structures section with Ian Giddy, NYU Stern School of Business, 2012

1730 - 1111 West Georgia Street Vancouver, BC Canada V6E 4M3 T 604.687.2663 www.bondcapital.ca

MEZZANINE FINANCE

Mezzanine investments are tailored investments that bring the preferred features of both debt and equity into a single facility. Mezzanine investors are often non-bank institutions and specialty funds seeking absolute return on capital. Mezzanine facilities are customized to the specific cash flow need of the investee Companies that use company, which not only helps the investee company mezzanine capital get more senior debt capital, but may also reduce the access more capital need for equity and thus dilution to the shareholders. and can achieve higher Common transactions that use mezzanine facilities include growth through expansion projects, acquisitions, returns on equity. recapitalizations, management buyouts, and leveraged buyouts. Companies that use mezzanine capital access more capital and can achieve higher returns on equity. The availability of mezzanine capital can be cyclical, while the amount used in any transaction is influenced by market leverage profiles and the availability of senior debt and equity sources. The pricing of a combination of senior debt and mezzanine debt can be comparable to that of a high yield note. Most mezzanine investments are repaid through cash generated by the business, a change-of-control sale or recapitalization of the company.

WHAT IS MEZZANINE DEBT?

Mezzanine debt capital generally refers to that layer of third party. Although it makes financing between a company’s senior debt and equity. up a smaller portion of a Structurally, it is subordinate in priority of payment and security company’s total available to senior debt, but greater in rank to common stock or equity. capital, mezzanine financing is (Exhibit 1) an important capital source, In a broader sense, mezzanine debt may take the form of filling in the gap between debt convertible debt, junior debt, subordinated debt, private and equity. “mezzanine” securities (debt with warrants or preferred equity), A mezzanine provider will or second lien debt, and is sometimes referred to as quasi- generally seek a risk profile equity. between that of senior debt Mezzanine capital is typically used to fund corporate growth and equity with corresponding opportunities such as an acquisition, new product lines, new pricing. Mezzanine debt can distribution channels, plant expansions, for company owners to often be thought of as take money out of the company for other uses, or to help borrowing equity and senior finance the sale of their business to management or another banks will treat it as such, while the cost of mezzanine debt will be less than equity because of the interest paid and security preference it takes ahead of equity. (Exhibit 2) While capital can be obtained from equity, equity is usually the most expensive and most dilutive source of capital. Shareholder dilution with mezzanine investments is less than with equity investments because much of the mezzanine return is from the loan repayment (interest and principal) rather than from capital gains. Additionally, it is common for a company to repurchase any equity issued to a mezzanine investor and revert back to its pre-financing equity structure.

MEZZANINE CAPITAL STRUCTURES

While there are no hard and in most mezzanine financing are subordinated notes with fast rules for optimizing a warrants for private companies, and high yield debt (junk company’s capital structure, bonds) or convertible / preferred shares for public companies. companies that use an efficient Mezzanine lenders, typically specialist mezzanine investment combination of senior debt, funds, look for a target rate of return which can be earned mezzanine debt, and equity through two basic components: current payment and deferred capital, seek to minimize their payments. weighted average cost of Mezzanine lenders will also often charge an arrangement capital (WACC) in order to boost fee, payable upfront at the closing of the transaction and shareholder return on equity ongoing administration fees to cover administrative costs and (ROE). as an incentive to complete the transaction. Mezzanine financing can be In structuring a mezzanine investment, the shareholders and completed through a variety of mezzanine investor work together to match the business’ structures based on cash flow, future free cash flow with any repayment obligation. A well- the specific objectives of the structured mezzanine investment will leave excess free cash transaction and the existing available to the company as a margin of safety for asset capital structure in place at the replacement and growth of the business. company. The basic forms used Mezzanine debt is shown to add significant capital, enabling

COMPARISON OF PAYMENT STREAMS Current Payments Deferred Payments Paid monthly, quarterly or annually Paid upon maturity of the mezzanine facility or late (Debt Attributes) (Equity Attributes) Cash Interest - a periodic payment of cash based upon a PIK interest - payable in kind interest is a periodic form of percentage of the outstanding balance of the mezzanine payment in which the interest payment is not paid in cash financing. The interest rate can be either fixed or floating. but rather paid in kind by increasing the principal amount through capitalization of the interest payment then due. Principal - scheduled repayments, a portion of which may be deferred until maturity and /or year-end cash sweeps Bonus / Exit Payment – fixed or variable payment that is based on a formula. negotiated. Variable payments are often calculated as a proxy for the business value or change in value of the Royalties – variable payments based on a prescribed company over the duration of the mezzanine facility. formula usually related to revenue, gross margin, EBITDA or net income. Equity Ownership - mezzanine capital will often include an equity stake in the form of attached warrants, a debt for shares conversion feature, or common shares of the company.

a company to grow while minimizing the issuance of equity. (Exhibit 3 & 4) On the positive side; the owners face little dilution and maintain control of the business; the company’s total cost of capital is reduced; and the mezzanine debt has a flexible payment term that is structured as “self liquidating” and is paid off over time, or is paid off all at the end (also known as a full bullet payment). On the negative side this is a debt structure that requires some interest payments over time; thus, there is less free cash available for growth and shareholder distributions. The table in Exhibit 5 outlines differences between capital sources.

SECURE MORE TOTAL CAPITAL

Some closely held companies, particularly those that are family controlled, are reluctant to consider mezzanine financing REASONS FOR THE because it requires relinquishing a certain amount of FUNDING GAP BETWEEN ownership. However, a mezzanine investor’s goal isn’t to be a SENIOR DEBT AND EQUITY 1. Accounts receivable, shareholder, but rather to achieve a target rate of return over a inventories and fixed assets selected period of time. A typical mezzanine transaction has are being discounted at the mezzanine fund as a small equity holder, with buyout terms greater rates than in the past to payout the mezzanine fund and repurchase the equity at the for fear that their values will appropriate time. More importantly, a business owner needs to not be realized in the future. analyze the difference in value between an ownership interest 2. Senior lenders are with the mezzanine investment and without. All else being reluctant to lend, or are equal, an improved valuation represents an improved return on against goodwill or equity for the shareholders. Another way to look at this intangible assets as calculation is: If the mezzanine investment costs less than the collateral. 3. Senior lenders may wish to incremental return on the equity it makes sense, if it costs more limit their exposure to any than the incremental return on equity then it should be one company or industry. considered less favourably. What’s more, having mezzanine 4. Equity may be limited or debt in place can actually help a company secure more total unavailable, prohibitively capital and reduce risk if it helps to properly capitalize the expensive, or highly dilutive. business. Exhibit 6 demonstrates how the addition of mezzanine capital provides more total capital to the business. Banks often look more favourably on companies that are backed by institutional investors such as mezzanine investors and may extend more credit under more attractive terms. This is a result of the mezzanine investors’ risk reducing reputation, and the increased involvement of the mezzanine lender with the company Having mezzanine debt in as compared to with a (senior) bank alone. place can actually help a Simply put, the risk to the bank’s investment company secure more total is reduced because of their knowledge that capital and reduce risk. the mezzanine lender through a more active role (often with a board seat), may enhance the success of the business. Additionally, mezzanine lenders are a source of reserve capital for a business, helping to diversify a company’s reliance on any one capital source.

LOWERING THE COST OF CAPITAL AND IMPROVING EQUITY RETURNS MEZZANINE INSTRUMENTS offer a risk/return profile In addition to securing more capital, a mezzanine structure that lies between debt and allows a business to reduce its cost of capital and boost both equity. return on equity and absolute profits. The following three cases in Exhibit 6 illustrate a traditional All Equity Company. MEZZANINE DEBT The result of the transition from an All Equity Company into is sometimes referred to as a Low Equity Company creates a more efficient capital quasi-equity. structure lowering the company’s cost of capital, improving the

ROE return on equity, and releasing significant new growth and Return on equity. acquisition capital to a company’s existing owners.

WACC Weighted average cost of capital.

IRR Internal rate of return.

EBITDA Net income with interest, taxes, depreciation and amortization added back to it.

IPO Initial public offering. The first time a company publicly sells shares on the open market.

CALL PROTECTION refers to a period of time during which a bond issuer cannot buy back a bond.

MEZZANINE RETURNS

Mezzanine investors include mezzanine investments have remained relatively constant over pension funds, hedge funds, the last 20 years. (Exhibit 7) leveraged public funds, Typically, mezzanine lending includes both subordinated business development debt and an equity component. The debt is usually issued with companies, private equity a cash pay interest rate of 10 to 14 percent and a maturity funds, insurance companies, as ranging from four to seven years with the ability of the well as banks that have borrower to buy out the debt earlier and repurchase any established stand-alone equity. Today’s mezzanine investors are looking for an IRR mezzanine efforts (also known (internal rate of return) between 11 and 25 percent compared as captives). Traditional to an IRR of 25+ percent for equity investors. If the pricing is mezzanine providers are book- equal mezzanine is more cost effective than equity in absolute and-hold investors, generally terms because of the tax shield generated from the tax focused on cash-flow lending, deductibility of the interest and anti-dilutive features. looking for a minimum term In the 2000's the proliferation of Buyout Funds (Private (call protection) and equity equity funds that focus on buying companies through participation to generate longer leveraged buyouts) created a market for specialized mezzanine term results. Unlike traded providers that focus on funding Buyouts. At the same time low equity, high-yield debt and interest rates and a supply of debt capital from central banks interest rates that fluctuate with have enabled increased leverage to mezzanine investors and economic conditions, the ability to sell mezzanine loans into securitized products like traditional mezzanine finance is the CLO (Collateral Loan Obligation) Fund. The credit crisis of a consistent and stable market 2008 resulted in a high percentage of mezzanine funds exiting targeting an absolute return. the market. The interest rate conditions continued to be The coupon rate on mezzanine favourable in the 2010's enabling a number of new funds to notes and targeted returns of enter the market replenishing the supply of mezzanine capital.

MEZZANINE TERMS

Exhibit 8 is an example of a mezzanine facility that is back measurement characteristics end loaded, meaning that payments (PIK interest, principal and are more tolerant. For instance, equity) are deferred until later in the facility term. It further if the maximum leverage of demonstrates the majority of the mezzanine investor’s return Debt/EBITDA on a bank deal usually comes from interest and not from gains on equity. were 3.0, a mezzanine deal While a mezzanine investment may be more expensive than would be closer to 4 or 5. traditional bank debt, it is not as strict. Generally, it shares the Mezzanine facilities are often same covenant package as a traditional bank deal, but the customized or “engineered” to

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match the cash flow profile of bank debt (often mezzanine debt) as a multiple of EBITDA for each company by changing the companies with less than $50MM in EBITDA. timing and amounts of current For smaller size companies, say $10MM in EBITDA, total debt and deferred payments to work availability might be 70-80% as much as for a larger $50MM with the senior bank debt EBITDA company. For example, an average highly leveraged requirements. company with EBITDA of $5 million per year in 2004 would Exhibit 9 depicts average have had 3.2 times EBITDA times ~80% or $13 million in bank debt multiples of US leveraged debt, with 1.0 times EBITDA times ~80% or $4 million in non- companies and differentiates bank debt for total leverage of 17/5 = 3.4x EBITDA. In addition between bank debt as a to size, industry stability or volatility and the availability of multiple of EBITDA, and non- collateral can have an impact on capital availability.

MEZZANINE AND HIGH YIELD DEBT

The average cost of senior structures, generally, a high yield debt offering requires a much debt and mezzanine debt in a larger minimum amount than a private debt solution, while the private company to publicly private debt solution would require a liquidity risk premium traded high yield notes is and therefore in theory cost more. Comparing high yield comparable. While there are interest rates with the average cost of private debt shows that pros and cons to both rates between the two can be quite similar. (Exhibit 10)

MEZZANINE EXIT

Most mezzanine investments are repaid through cash deployment, which receives a generated by the business, a change-of-control sale or return commensurate with the recapitalization of the company. Many mezzanine capital risk being taken. It is very providers believe the IPO “home run” is a rarity. While some common that mezzanine mezzanine providers may look to invest in companies that investors are bought out by the represent strong IPO candidates, more frequently the initial owner. mezzanine capital provider is looking for longer term capital

About Bond Capital

Bond Capital is an award winning institutional provider of structured business debt and equity to successful business owners and management teams wishing to capitalize for growth, acquisitions, or buyouts. As a true entrepreneurial partner, Bond Capital identifies common goals and objectives, tailors a creative financial solution, and provides the necessary investment in real dollars. Since 2002, Bond Capital has provided funding and advice to later stage companies with strong management teams and EBITDA between $2 million and $50 million, making direct investments between $2 million and $30 million. Bond Capital has also arranged syndicated transactions ranging up to $250 million.

Bond Capital was named by Preqin for best global performance by a mezzanine debt fund for 2015, 2016 & 2017. Bond Capital is located in Vancouver, Canada.

About the Authors

Corry J. Silbernagel, PEng, MBA Davis V. Vaitkunas, BComm understands how to determine the right mix has spent over twenty years advising of debt and equity to amplify investee business owners about finance, capital companies’ success using cash flow analysis structure strategy, raising capital, and the and other tools. As managing director and cost of capital. Davis has funded over 150 head of originations at Bond Capital, Corry is transactions using a wide variety of creative responsible for new investment capital solutions. As the founder and opportunities. managing partner of Bond Capital, Davis has successfully raised and deployed multiple Corry’s strong operational finance skills come Bond Capital private equity funds. from twenty years working as a management consultant, CFO, project engineer, and In addition to being a banker, Davis is a engineering project manager at some of successful entrepreneur who understands Canada’s largest energy companies and for a sales. He formerly worked in the information leading global engineering firm. Corry enjoys technology industry implementing enterprise participating as a board member and resource planning (ERP) software, hardware, treasurer for various public companies, and network solutions for large private companies, and not for profit manufacturing and retail clients at a Global organizations. 100 Corporation.